Compliance Testing Required for 401(k) Plans

Qualified retirement plans must provide benefits to plan participants in a non-discriminatory manner. Current required anti-discrimination testing involves Top-Heavy Determination, 401(k)/401(m) Discrimination Testing and 410(b) Coverage Testing. Top-Heavy Determination Test focuses on the definition of a Key Employee while 401(k)/401(m) and 410(b) testing focuses on the definition of a Highly Compensated Employee. While these concepts are similar in some respects, their actual definitions and applications are uniquely different.

Key Employee Defined

  • A 5% owner without regard to compensation, or
  • 1% owner whose annual compensation is over $150,000, or
  • Officers with annual compensation in excess of $170,000 (in 2014).

Highly Compensated Employee (HCE) defined:

  • A 5% owner of the Employer or an Affiliate in the current or the immediately preceding plan year, or
  • Any employee that earned more than $115,000 in the 2013 plan year will be considered an HCE for the 2014 plan year.

Constructive ownership rules apply attributing ownership to spouses and lineal ascendants and descendants (parents, grandparents, children and grandchildren) of the owner in both of the above employee definitions.

Top Heavy Determination and Top Heavy Requirements:

The purpose of the Top Heavy Requirements is to ensure that qualified plans do not unfairly benefit the Key Employees of the employer. If, on the Determination Date, the total of the account values for the Key Employees exceeds 60% of the account values for all employees, it will be determined to be Top Heavy. A minimum Top Heavy Contribution will be required for the initial plan year and/or the following plan year if the Key Employees receive any contribution allocation. This contribution must be 3% of the Non-Key employee’s total annual compensation or if less, the highest percentage of compensation that any Key Employee receives. The Top Heavy Contribution is allocated to the eligible Non-Key employees who are employed on the last day of the plan year without regard to the number of hours worked. Key Employees may receive a Top Heavy Contribution if elected in the Plan Document.

401(k) / 401(m) Discrimination Testing:

The purpose of the discrimination test is to ensure that Highly Compensated Employees do not receive contributions on average that are substantially greater than Non-Highly Compensated Employees. A general description of the test follows:

The discrimination test divides participants into two groups, Highly Compensated and Non-Highly Compensated. Once the groups are separated, contribution ratios are developed for salary deferrals and employer matching contributions for each participant. The ratios are averaged for both the Highly Compensated Group and Non-Highly Compensated Group. This creates the ADP (Actual Deferral Percentage) and the ACP (Actual Contribution Percentage), which are compared to the following table to see if the plan is within passing guidelines.

ADP or ACP of the NHCE Group

Maximum ADP or ACP of the HCE Group

0% - 2%

0% - 4% (i.e. x2)

2.1% - 8%

4.1% - 10% (i.e. +2)



If the plan is outside of these guidelines, corrective measures are required. The most common method of correction is issuing corrective distributions to the Highly Compensated Employees. If corrective distributions, including earnings, are not made by 2½ months after the plan year-end, a penalty tax will be imposed on the employer equal to 10% of the excess contributions. If the corrective distributions are not returned by the end of the plan year following the plan year in which the test failed, plan qualification may be jeopardized.

Participation of Non-Highly Compensated Employees is important. Since the maximum ADP permitted for the Highly Compensated Group of employees is dependent upon the ADP for the Non-highly Compensated Group of employees, participation by NHCEs is key to any successful 401(k) plan. Matching contributions are also an important factor. If the employer contributes an amount only when the employee defers, the employee may be more inclined to participate.

410(b) Coverage Testing:

A retirement plan must satisfy coverage testing in order to qualify for favorable tax treatment. The purpose of the test is to ensure that the plan does not discriminate in favor of highly compensated employees in regards to eligibility for benefits. The ratio percentage test is the most commonly used coverage test. Under this testing method, the percentage of the NHCEs who benefit under the plan (including terminees with more than 500 hours of service) must equal at least 70 percent of the percentage of the HCEs who benefit under the plan.

Generally, if a plan excludes no employee groups other than non-resident aliens or union employees, the 410(b) test is passed. If there are affiliated or commonly controlled companies in the employer group and a segment of the companies is not included in the retirement plan then particular attention should be placed on this test.

Maximum Limit on Elective Deferral Contributions:

Effective January 1, 2014, a participant’s elective deferral contributions under all retirement plans in which he or she participates during any taxable year is limited to $17,500. Plans may permit participants who have reached age 50 by the end of the plan year to make annual catch-up contributions of an additional $5,500 once the annual dollar limit or a plan-imposed limit on elective deferrals has been reached.

The limitation on elective deferrals applies to the participant’s tax year, which is usually a calendar year. For participants who exceed the limitations, corrective distributions should be made no later than April 15th following the close of the taxable year. If excess deferrals are not timely corrected, double taxation will occur: the amount of the excess will be included in the participant’s income for the taxable year in which the excess arose and again in the year of the distribution.

Maximum Annual Additions:

The Internal Revenue Code sets limits on contributions made to a participant’s account. The Code uses the term “annual additions” which represents both employee and employer contributions as well as reallocated forfeitures. Effective January 1, 2014, the annual dollar limit is the lesser of 100% of compensation or $52,000.

Excluded Compensation Testing:

If the Plan excludes certain types of compensation, for instance: bonuses or overtime, additional testing must be done to ensure that the exclusion does not discriminate in favor of the HCEs. In general, the average of the ratio of included compensation to total compensation for the HCE group may not be more than a de minimis amount higher than the average of the ration of included compensation to total compensation for the NHCE group. The IRS has used 3%-5% as a safeguard, but each plan is viewed on a facts and circumstances basis.

In summary:

This has been a broad overview of the general testing requirements for 401(k) plans and is not meant to be comprehensive. To learn more about the testing requirements for your specific plan, please contact us.Contact us today

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Types of ERISA Fiduciaries

Under ERISA, there are several named classes of Fiduciaries, first and foremost of which is the Plan Sponsor. All qualified retirement plans have at least one named Plan Sponsor. The Plan Sponsor adopts the plan, and only employees (or beneficiaries thereof) of the adopting Plan Sponsor (or sponsors) may participate in and benefit from the plan. Since many Plan Sponsors of qualified retirement plans like to limit their fiduciary risk when it comes to the investment and disbursement of Plan Assets, it is possible for Plan Sponsors to mitigate their fiduciary liability by naming specific entities or individuals as fiduciaries. This article takes a look at determining who is a Plan Administrator, at investment advisors as fiduciaries, and the benefits of naming specific parties as certain types of named fiduciaries.

Plan Administrator under ERISA 3(16)

The Plan Administrator is responsible for the day to day duties of the plan, including determination and transmittal of contributions; distribution and loan review, approval and processing; annual compliance testing and the preparation of Form 5500 and related schedules. A Plan Sponsor can certainly hire outside service providers to handle most of these tasks, but unless the service provider specifically accepts Fiduciary status under ERISA Section 3(16), the Plan Sponsor or other specifically named parties are still considered the Plan Administrator, with all of the related Fiduciary Liability. To determine who is a Plan Administrator under 3(16), first review the Plan’s document. The Plan Administrator will be the individual named in the document. If the document does not name an individual, then the Plan Sponsor is the Plan Administrator. In the case where there are multiple employers, then the association, committee, joint board or trustees or other similar group of representatives of the parties who establish and maintain the plan may be named Plan Administrator. Some service providers are beginning to offer these services, for a fee, specifically accepting the title of 3(16) Plan Administrator.

Investment Advisors as Fiduciaries

A qualified plan financial adviser (or investment advisor) is a term for professionals who sell, advise, market or support qualified retirement plans. According to the U.S. Financial Industry Regulatory Authority (FINRA), terms such as financial adviser and investment advisor are general terms or job titles used by investment professionals and do not denote any specific designations.

ERISA 3(21) Fiduciaries

An investment advisor may be appointed as a fiduciary under 3(21) of ERISA directly by the Plan Sponsor. Persons can be deemed a 3(21) Fiduciary to the extent that they meet the following criteria; if they:

  • Exercise discretionary authority or control with respect to the management of the plan and the disposition of plan assets
  • Render investment advice for a fee or any other direct or indirect compensation; or
  • Have any discretionary authority or responsibility over the administration of the Plan

 Fiduciaries accepting 3(21) responsibility share that responsibility with the Plan Sponsor and Plan Administrator; however the Plan Sponsor retains the ultimate responsibility and must monitor the performance of the 3(21) fiduciary. For instance, an investment advisor accepting ERISA 3(21) responsibilities may recommend a potential menu of investment options for the plan, but it is up to the Plan Sponsor to accept or reject those investment options, and to ensure that the investment policy is enforced.

ERISA 3(38) Fiduciaries

A fiduciary who falls under 3(38) of ERISA must be a registered investment advisor, bank, or insurance company. This type of fiduciary has all of the responsibilities of a 3(21) fiduciary, however they must agree in writing to assume the liability of selecting and monitoring the investments of the Plan. A 3(38) fiduciary has full discretion for selecting and monitoring plan investments and must make judicious decisions when making their investment choices. This type of fiduciary assumes the legal responsibility and liability of investment decisions. Bringing forward our previous example, the investment advisor accepting ERISA 3(38) responsibilities may recommend a potential menu of investment options for the plan, however neither the Plan Administrator nor the Plan Sponsor would have a say in the ultimate investment of the funds.

Benefits of Naming a Fiduciary

From investments to the day to day management of the plan, it is not always possible for a Plan Sponsor be an expert in all aspects of a qualified plan. Hiring experts to help with these important and sometimes confusing requirements is not only prudent but may help limit the overall liability a Plan Sponsor is exposed to. For smaller plans, however, it may cost prohibitive to appoint an outside fiduciary. As the assets of the plan grows, so does the potential fiduciary liability and therefore the potential need for a named outside fiduciary. Ultimately, it is up to the Plan Sponsor to evaluate their own need and determine the scope of such an undertaking. More importantly, the Plan Sponsor also has the responsibility to monitor the fiduciary, as it would any other service provider, and make prudent decisions in selecting a 3(16), 3(21) or 3(38) fiduciary. The act of hiring such a fiduciary is itself a fiduciary act, so there is no way to eliminate all fiduciary liability. By making sensible, well documented decisions, and monitoring the results of the decisions, a Plan Sponsor can best defend themselves against any potential future litigation. The Sponsor must also take steps to ensure that the services received are commensurate with the cost of those services. There is no requirement under ERISA that any plan costs must be the cheapest around, only reasonable.

Meeting your fiduciary obligations under ERISA can be nuanced and not always obvious. You may also want to read our blogs in our fiduciary series, Are You a Fiduciary? and Fiduciary Responsibilities for Benefit Plans under ERISA.

 If you have questions about your particular responsibilities or risk, feel free to Contact us today.

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Are You a Fiduciary?

Fiduciaries of qualified retirement plans are held to the highest of federal standards. Fiduciary violations under the Employee Retirement Income Security Act (ERISA) of 1974 can expose you and your employer to risk and litigation. In some circumstances, fiduciaries can be held personally responsible for losses and restitution.

Not all fiduciaries are identified by title. Furthermore, some individuals may play a fiduciary role in some of their functions but not other functions. So how might you know if your position places you in a fiduciary role, or if your actions are subject to ERISA's fiduciary standards?

There are innumerable journal articles, books and court cases that parse the question of who is held accountable for fiduciary conduct regarding benefit plans under ERISA. Here are some commonly held distinctions between a plan fiduciary and a non-fiduciary.

Functions Tell More than Titles

Fiduciary status is based on functions performed, not just titles. Under ERISA, the litmus test is whether you exercise discretionary authority in administering and managing a plan or in controlling the plan's assets. You will be viewed as a fiduciary to the extent of your authority, control or discretion.

Fiduciaries Named in the Written Plan Document

Written plan documents must name at least one official Fiduciary, by name or by office, or through a process described in the plan, as having control over the operation of the plan. The named Fiduciary can include one or more individuals; as well as entities such as an administrative committee or the company's board of directors. Plan fiduciaries may typically include:

  • The Trustee
  • Persons exercising discretion in the administration of the plan
  • Members of a plan's administrative committee (if the committee exists)
  • Persons who select committee officials
  • Investment advisers

Professionals and Fiduciary Responsibility

Professionals providing services are generally not considered fiduciaries when they are acting solely in their professional capacities. Professionals who commonly provide services include:

  • Attorneys
  • Accountants
  • Actuaries
  • Consultants

However, to the degree that a professional exercises authority or control over a plan, he or she can be liable for fiduciary actions. For example, a professional who is given compensation to provide investment advice for the plan or to administer a plan would be performing fiduciary functions.

Business Decisions vs Fiduciary Decisions

Business decisions are not governed by ERISA. Since employers are not required to provide retirement plans for employees, ERISA views the decision to establish a benefits plan as a business decision because the employer is acting on behalf of the business.

Other business decisions can include the determination of:

  • the benefit package.
  • certain features to be included.
  • whether or not to amend a plan.
  • whether or not to terminate a plan

However, once employers (or those hired by them) act to implement a qualified benefits plan, they are acting on behalf of the plan, and their decisions in carrying out the plan are considered fiduciary decisions, subject to ERISA regulations governing fiduciary responsibilities.

Specific Situations

Given the nuances of fiduciary codes, the Department of Labor, which enforces ERISA laws, has demonstrated over the years that final determination of fiduciary liability and responsibility rests on the intersection of the specific circumstances of each situation and the prevailing regulations.

If you have a specific question regarding fiduciary roles, naming a fiduciary, or the delegation of fiduciary duties, it is best to seek professional expertise.

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